Managerial Economics &
Business Strategy
Chapter 6
The Organization of the Firm
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy
Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
6-2
Overview
I. Methods of Procuring Inputs
Spot Exchange
Contracts
Vertical Integration
II. Transaction Costs
Specialized Investments
III. Optimal Procurement Input
IV. Principal-Agent Problem
Owners-Managers
Managers-Workers
6-3
Manager’s Role
• Procure inputs in the least
cost manner, like point B.
• Provide incentives for
workers to put forth effort.
• Failure to accomplish this
results in a point like A.
• Achieving points like B
managers must
Use all inputs efficiently.
Acquire inputs by the least
costly method.
Costs
C(Q)
A
$100
80
B
Q
0
10
6-4
Methods of Procuring Inputs
• Spot Exchange
When the buyer and seller of an input meet, exchange,
and then go their separate ways.
• Contracts
A legal document that creates an extended relationship
between a buyer and a seller.
• Vertical Integration
When a firm shuns other suppliers and chooses to
produce an input internally.
Key Features
• Spot Exchange
Specialization, avoids contracting costs, avoids costs of
vertical integration.
Possible “hold-up problem.”
• Contracting
Specialization, reduces opportunism, avoids skimping
on specialized investments.
Costly in complex environments.
• Vertical Integration
Reduces opportunism, avoids contracting costs.
Lost specialization and may increase organizational
costs.
6-5
6-6
Transaction Costs
• Costs of acquiring an input over and above
the amount paid to the input supplier.
• Includes:
Search costs.
Negotiation costs.
Other required investments or expenditures.
• Some transactions are general in nature
while others are specific to a trading
relationship.
Specialized Investments
• Investments made to allow two parties to exchange
but has little or no value outside of the exchange
relationship.
• Types of specialized investments:
Site specificity.
Physical-asset specificity.
Dedicated assets.
Human capital.
• Lead to higher transaction costs
Costly bargaining.
Underinvestment.
Opportunism and the hold-up problem.
6-7
6-8
Specialized Investments
and Contract Length
$
MC
MB1
Due to greater need for
specialized investments
MB0
Longer Contract
0
L0
L1
Contract
Length
6-9
Specialized Investments
and Contract Length
$
More complex
contracting
environment
MC2
MC0
MB0
Shorter Contract
0
L2
L0
Contract
Length
6-10
Specialized Investments
and Contract Length
$
MC0
MC1
Less complex
contracting
environment
MB0
Longer Contract
0
L0
L0
Contract
Length
6-11
Optimal Input Procurement
No
Substantial
specialized
investments
relative to
contracting costs?
Yes
No
Contract
Spot Exchange
Complex contracting
environment relative to
costs of integration?
Yes
Vertical
Integration
6-12
The Principal-Agent Problem
• Occurs when the principal cannot observe the effort of
the agent.
Example: Shareholders (principal) cannot observe the effort of the
manager (agent).
Example: Manager (principal) cannot observe the effort of workers
(agents).
• The Problem: Principal cannot determine whether a
bad outcome was the result of the agent’s low effort or
due to bad luck.
• Manager’s must recognize the existence of the
principal-agent problem and devise plans to align the
interests of workers with that of the firm.
• Shareholders must create plans to align the interest of
the manager with those of the shareholders.
6-13
Solving the Problem Between
Owners and Managers
• Internal incentives
Incentive contracts.
Stock options, year-end bonuses.
• External incentives
Personal reputation.
Potential for takeover.
6-14
Solving the Problem Between
Managers and Workers
•
•
•
•
Profit sharing
Revenue sharing
Piece rates
Time clocks and spot checks
6-15
Conclusion
• The optimal method for acquiring inputs
depends on the nature of the transactions
costs and specialized nature of the inputs
being procured.
• To overcome the principal-agent problem,
principals must devise plans to align the
agents’ interests with the principals.
